Parent-Subsidiary Structures – Part I: Control and Separateness

There are a variety of reasons that a parent-subsidiary structure between a nonprofit and for-profit entity can be an attractive corporate structure whether initiated by a nonprofit or for-profit. A nonprofit may desire to move a program that would otherwise be characterized as a substantial unrelated business activity into a for-profit subsidiary in order to protect its tax-exempt status. This is what led the nonprofit Mozilla Foundation (best known for its Firefox browser) to create its for-profit subsidiary, Mozilla Corporation. A for-profit, on the other hand, may desire to set up a private foundation in the same name to carry out grantmaking in support of charitable causes that are of interest to the for-profit. Google Foundation, for example, is a nonprofit subsidiary of Google, Inc. and carries out grantmaking activities in furtherance of charitable, scientific, and educational purposes within the meaning of section 501(c)(3) of the Internal Revenue Code.

Under certain circumstances, the parent-subsidiary structure can work well by allowing each entity to utilize its relative advantages as a nonprofit or for-profit entity. In addition, the parent corporation may be afforded some control while concurrently benefitting from less exposure to the subsidiary’s liabilities. However, under some circumstances, this relationship can go awry, particularly when a large majority of the subsidiary’s directors and officers lack independence from the parent or the entities fail to respect corporate formalities. Additionally, when the relationship involves nonprofit and for-profit entities, the nonprofit should reasonably expect that any business relationships might be scrutinized for private benefit issues and should also explore the potential tax implications of those transactions. Accordingly, the decision to create a parent-subsidiary structure should take into account many important considerations, some of which are highlighted below.

Control

One benefit for the parent of a parent-subsidiary structure is the element of control. For example, the nonprofit parent may own all or a majority of the voting shares of its for-profit stock corporation subsidiary or a for-profit parent may be the sole voting member of its nonprofit subsidiary. This generally means the parent has the power to elect and remove the subsidiary's directors and the power to approve and amend the subsidiary's governing documents. Therefore, the parent is able to exercise substantial control over the subsidiary by controlling who is on the board and how the organization is to be governed.

Importantly, both the parent and subsidiary should understand the difference between the control that can be exercised by the parent and the independence that should be exercised by the subsidiary. Common issues include:

Fiduciary duties. The parent may control which individuals constitute the leadership of the subsidiary, but those individuals serve on behalf of the subsidiary, not the parent. Therefore, it is critical that the directors and officers of the subsidiary understand their fiduciary duties as they relate to the subsidiary especially when the best interests of the parent and the best interests of the subsidiary do not align.

Overlapping directors and officers. Practically speaking, many parent corporations would prefer to elect their own directors and officers to also govern the subsidiary organization. However, having a majority of non-overlapping directors and officers between the parent and subsidiary is generally recommended for a variety of reasons including the difficulty posed in practice to overlapping directors and officers in wearing “two hats” with competing loyalties, and the need to establish separateness between the entities (discussed in the next section).

Management of the subsidiary. The parent may hold the directors and officers accountable for the performance of the subsidiary, but generally, the parent corporation should neither dictate the management nor the management decisions of the subsidiary.

Separateness

Another benefit for the parent of a parent-subsidiary structure is protection from the subsidiary’s liabilities. The general rule is that a parent corporation will not be held liable for the acts of its subsidiaries. This rule, however, is not absolute. Liabilities of the subsidiary may be imposed on the parent on an “alter-ego” theory or what is known as “piercing corporate the veil.” The alter-ego theory is generally governed by state law and based on a) a lack of separateness between the two corporate entities or b) wrongful use of the corporate structure that causes injury.

Issues with respect to separateness commonly arise when the entities fail to respect corporate formalities through actions such as:

Failing to negotiate business transactions between the parent and subsidiary at arm’s length;

Entering into business transactions favorable to the parent;

Undercapitalizing the subsidiary; and

Agreeing to payment by the parent of the subsidiary’s debts.

Additionally, although resource sharing agreements between a parent and subsidiary are not per se prohibited, they can be ripe with trouble for the unwary. It is not uncommon for a parent and its subsidiaries to desire to share resources such as office space or certain employees to maximize efficiency and lower costs; however, such arrangements should be carefully vetted because they may evidence a lack of corporate separateness when improperly structured. Furthermore, even if such arrangements are legally sound from a corporate and tax law perspective, it would be prudent for the parent and subsidiary corporation to have a thorough understanding about the liabilities and responsibilities accepted by both parties under such agreements. For example, a parent may be directly liable for any obligations to the subsidiary’s employees under a shared employee benefit program.

Part II on business transactions and unrelated business income coming soon!

13 Responses to “Parent-Subsidiary Structures – Part I: Control and Separateness”

ahmad Faramarzi

I have setup a non-profit to support a government contract which required that status. We do not get any donation; we compete and win contracts. Because of the non-profit status, we are not classified as a Small Business in the government world. We like to setup a for-profit as the parent of non-profit. The non-profit has little asset and a subcontract with another Non-profit to provide scientific and engineering support to them in support of the prime’s contract with the government. I can see the separation issues of the two entities and can comply with those considerations easily. How can I “sell” or “put” the non-profit under the new for-profit entity?

Gene Takagi

You should engage a knowledgeable lawyer to help with this potentially very complicated matter. Having a for-profit as the parent of the nonprofit is certainly possible, but it raises more private benefit (and potentially self-dealing) concerns related to both any benefits the nonprofit is providing to the for-profit and any benefits the nonprofit is providing to the owners of the for-profit. Generally, a for-profit cannot “buy” a nonprofit, which has no owners. A nonprofit’s board might amend its bylaws to provide for a for-profit entity to be the sole member or designator of a majority or all of the directors, but the board would have to be able to defend such action as being in the best interests of the nonprofit.

Gene Takagi

This sounds a little like Model L fiscal sponsorship. See http://www.nonprofitlawblog.com/nonprofit-limited-liability-company-2/. Note that a parent-sub relationship generally means that the parent owns 100% of the sub, which exists as a separate legal entity (typically for liability purposes but not necessarily for income tax purposes). If the sub is not a separate legal entity, the “parent” may simply be adding new divisions/programs/internal projects for which it is fully responsible.

Courtney

Great article! Suppose I have a for-profit dance company, and I want to create a non-profit subsidiary to allow under-privileged kids to take dance classes at my studio. The parent company will provide the dancing instructions, but the subsidiary would apply for and receive the grant money. Is there a way to structure this relationship without failing to respect corporate formalities?

Ramit

Hello. I was curious to learn about more companies that follow the subsidiary structure with the non-profit as the parent. I’m currently doing a project in business school and need to cite multiple examples. Would appreciate your guidance!

Gene Takagi

Universities often have for-profit subsidiaries. Prior to its restructuring with Fox, National Geographic Society was a nonprofit with for-profit subsidiaries. While I’m not very familiar with IKEA’s structure, I believe it may be owned by a nonprofit, the INGKA Foundation. Many museums also own for-profit subsidiaries.

Peter

I wanted to confirm that under the heading “Control, and the bulleted point “Overlapping directors and officers,” that you meant to say: “[h]aving a majority of non-overlapping directors and officers between the parent and subsidiary is generally recommended for a variety of reasons…”

It seemed to me as I was reading that you had primed to say “not” recommended.

Thanks for your confrmation.

Gene Takagi

Having a majority of non-overlapping directors and officers between the parent and subsidiary is generally recommended for a variety of reasons. Where a majority overlap, there may be difficult conflict of interest and alter ego issues to manage.